A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Christensen, Anders Møller Working Paper The real interest rate gap: Measurement and application Danmarks Nationalbank Working Papers, No. 6 Provided in Cooperation with: Danmarks Nationalbank, Copenhagen Suggested Citation: Christensen, Anders Møller (2002) : The real interest rate gap: Measurement and application, Danmarks Nationalbank Working Papers, No. 6, Danmarks Nationalbank, Copenhagen This Version is available at: http://hdl.handle.net/10419/82359 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu DANMARKS NATIONALBANK WORKING PAPERS 2002 • 6 Anders Møller Christensen Danmarks Nationalbank The Real Interest Rate Gap: Measurement and Application October 2002 The Working Papers of Danmarks Nationalbank describe research and develop- ment, often still ongoing, as a contribution to the professional debate. The viewpoints and conclusions stated are the responsibility of the individual con- tributors, and do not necessarily reflect the views of Danmarks Nationalbank. As a general rule, Working Papers are not translated, but are available in the origi- nal language used by the contributor. Danmarks Nationalbank's Working Papers are published in PDF format at www.nationalbanken.dk. A free electronic subscription is also available at this Web site. The subscriber receives an e-mail notification whenever a new Working Paper is published. Please direct any enquiries to Danmarks Nationalbank, Information Desk, Havnegade 5, DK-1093 Copenhagen K Denmark Tel: +45 33 63 70 00 (direct) or +45 33 63 63 63 Fax: +45 33 63 71 03 E-mail: [email protected] Nationalbankens Working Papers beskriver forsknings- og udviklingsarbejde, ofte af foreløbig karakter, med henblik på at bidrage til en faglig debat. Synspunkter og konklusioner står for forfatternes regning og er derfor ikke nød- vendigvis udtryk for Nationalbankens holdninger. Working Papers vil som regel ikke blive oversat, men vil kun foreligge på det sprog, forfatterne har brugt. Danmarks Nationalbanks Working Papers er tilgængelige på Internettet www.nationalbanken.dk i pdf-format. På webstedet er det muligt at oprette et gratis elektronisk abonnement, der leverer en e-mail notifikation ved enhver udgivelse af et Working Paper. Henvendelser kan rettes til: Danmarks Nationalbank, Informationssektionen, Havnegade 5, 1093 København K. Telefon: 33 63 70 00 (direkte) eller 33 63 63 63 Fax: 33 63 71 03 E-mail: [email protected] Det er tilladt at kopiere fra Nationalbankens Working Papers – såvel elektronisk som i papirform – forudsat, at Danmarks Nationalbank udtrykkeligt anføres som kilde. Det er ikke tilladt at ændre eller forvanske indholdet. ISSN (trykt/print) 1602-1185 ISSN (online) 1602-1193 Resumé Til empiriske formål foreslås det at fastlægge realrentegabet som en simpel trans- formation af forskellen på to nominelle rentesatser, nemlig centralbankens penge- politiske rente og renten på lange statsobligationer. Sidstnævnte rummer informa- tion om inflationsforventninger og realafkastet på andre aktiver. Den foreslåede be- regningsmetode benyttes til en empirisk analyse af de senere års pengepolitik i nogle få lande. Der fremkommer nogle nye, men foreløbige fortolkninger, specielt vedrørende USA og Sverige. Der fremføres desuden argumenter for at inkludere beregningsmetoden, hvis resultater er umiddelbart tilgængelige i realtid, i analy- serne inden for ECBs første søjle. Abstract For empirical purposes it is suggested to approximate the real interest rate gap by a simple transformation of the difference between two nominal interest rates, the central bank's policy rate and the long-term interest rate. The latter contains infor- mation on inflationary expectations and expected real returns from other assets. The suggested measure is used for an empirical analysis of recent monetary policy in a few countries and some new, although preliminary interpretations are obtained, in particular concerning the US and Sweden. In addition, arguments are put for- ward to include the measure in the analyses under the first pillar of the ECB. The measure is readily available in real time. The Real Interest Rate Gap: Measurement and Application Anders Møller Christensen, Danmarks Nationalbank1 Abstract For empirical purposes it is suggested to approximate the real interest rate gap by a simple transformation of the difference between two nominal interest rates, the central bank's policy rate and the long-term in- terest rate. The latter contains information on inflationary expectations and expected real returns from other assets. The suggested measure is used for an empirical analysis of recent monetary policy in a few countries and some new, although preliminary interpretations are obtained, in particular con- cerning the US and Sweden. In addition, arguments are put forward to in- clude the measure in the analyses under the first pillar of the ECB. The measure is readily available in real time. Problem The concept of a neutral or natural interest rate has been given new life in recent monetary theory. As a consequence, the concept of the real interest rate gap has been introduced in the theoretical models. If the central bank's (real) rate of interest exceeds the natural rate of interest, the real interest rate gap is positive and monetary policy is contractive. The natural interest rate is the short-term real interest rate that is consistent with output in the me- dium term converging towards the potential output, which again is the level of output compatible with stable inflation. The natural interest rate and its accompaniment, the real interest rate gap, have so far not been introduced in practical monetary policy in any system- atic way, although some first attempts can be seen, cf. BIS (2002). In the following it is argued that taking these concepts into greater account can give monetary policy a firmer anchor, and thereby reduce the risk of the central bank either conducting a purely discretionary monetary policy or a monetary policy which for extended periods is inappropriately tight or ex- pansionary as a consequence of an unclear guiding point in the real world. The focus will be on a simple method to determine the real interest rate gap in real time by considering two nominal interest rates: the central bank's 1 Constructive comments from Niels Thygesen, Claus Vastrup, participants at the EPRU Network Conference in May 2002 at the University of Copenhagen and from colleagues at the Nationalbank on previous versions are gratefully acknowledged. Remaining er- rors and shortcomings are the responsibility of the author. E-mail: [email protected] 2 interest rate and the long-term interest rate which in free markets is for- ward-looking in terms of inflation and alternative real returns. Historical real interest rate gaps are calculated for a few countries and for the euro area, and the time series are used to analyse monetary policy in recent years. The analysis shows that the real interest rate gap can give a better under- standing of the monetary policy conducted in the USA, and that taking ac- count of the consequences of a real interest rate gap could probably have led to a more appropriate Swedish monetary policy in a recent period. It is also argued that analysis of the real interest rate gap can enhance the ECB's first pillar. The real interest rate gap gives an indication of the degree of tightness of monetary policy, but further analysis is required to assess whether this is appropriate or not. Deviations from neutral are the core aspect of policy- making and a purely technical answer is not available. The model frame Recent years' analyses of monetary policy have focused on various topics related to inflation-targeting and policy rules. There has been an approxi- mately shared framework consisting of a simple macro model for a closed economy with an aggregate supply curve and an aggregate demand curve. In this paper most nuances of the different variants in terms of formation of expectations, lags and parameter restrictions will be omitted, and in contrast to tradition there will be no calibration and evaluation of optimality proper- ties, mainly because the objective is to demonstrate the strength of a simple analysis that can take part of the assessment of monetary policy in real time, irrespective of the central bank's concrete monetary-policy strategy. e n (1) p = p(p , p-k, u–u , z, ep) n n n n (2) u – u = u(E[u–u ], (u–u )-k, r–r , z, eu) (3) r • i – pe e In (1) p designates current inflation, p current inflation expectations, p-k lagged inflation, u–un unemployment's deviation from natural employment (or the output gap), and z other significant economic factors, while ep is an independent, identically-distributed residual term. The dating is not stated explicitly. Subject to appropriate restrictions on the parameters there will be a vertical supply curve in the long term. n n In (2) E[u–u ] designates the expected output gap, (u–u )-k the lagged output gap, r–rn the deviation of the real interest rate from the natural real interest rate, and eu an independent, identically distributed, residual term.